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4
Income
Measurement and
Accrual Accounting
PowerPoint Author: Catherine Lumbattis
COPYRIGHT © 2011 South-Western/Cengage Learning
Recognition and Measurement
Recognition: formally
recording an item in the
financial statements of
an entity
...but at
current value
or historical
cost?
I know I
need to
record
this...
Measurement:
quantification of the
economic effects of
the item on the entity
LO1
Cash vs. Accrual Basis
Cash basis: revenues and expenses are
recorded only when cash is received or paid
Accrual basis: revenues are recognized when
earned; expenses are recognized when incurred
LO2
Cash basis
statement
Accrual basis
statement
Statement of
Cash Flows
Income
Statement
Cash flows from
operating activities:
Net income:
$ 7,000
$(4,000)
What accounts for
the difference?
Revenue Recognition Principle
Revenue is recognized when realized and
earned—usually at time of sale
Exceptions:
 Long-term contracts
 Franchises
 Commodities
 Installment sales
 Rent and interest
LO3
Matching Principle
Match expenses with associated revenues
Directly
e.g., Inventory
Indirectly over
period they
provide benefits
e.g., Buildings
Simultaneously
upon their
acquisition
e.g., Utilities
LO4
Expense Recognition
Income Statement
Balance Sheet
EXPENSES:
ASSETS:
Inventory
Supplies
Prepaid assets
PP&E
Intangibles
when sold
Cost of goods sold
as used
Supplies expense
Insurance expense
Rent expense
over period they
provide
benefits
l
Depreciation expense
Amortization expense
Other expenses
(as incurred)
Types of Adjusting Entries
Deferred
expense
Accrued
asset
RECOGNIZE
REVENUE OR
EXPENSES
BEFORE OR AFTER
CASH IS
EXCHANGED
Accrued
liability
Deferred
revenue
LO5
Deferred Expense
Cash paid before expense is incurred
 Examples:
•
•
•
•
Prepaid rent
Prepaid insurance
Office supplies
Property and equipment
 Costs are initially recorded as assets and
allocated to expenses in future periods
Deferred Expense Example #1
Prepay rent on office space for one year on September 1
Initial journal entry:
9/1
Prepaid Insurance
2,400
Cash
2,400
Monthly adjusting journal entry:
9/30 Insurance Expense
200
Prepaid Insurance
200
($2,400 annual × 1/12 = $200 per month for 12 months)
Deferred Expense Example #2
Purchase new store fixtures on January 1 for $5,000.
Estimated useful life is 5 years (60 months); estimated
salvage value is $500
Initial journal entry:
1/1 Store fixtures
5,000
Cash
5,000
Monthly adjusting journal entry:
1/31 Depreciation Expense
75
Accumulated Depreciation
75
($5,000 – $500) × 1/60 = $75 per month for 60 months)
Deferred Revenue
Cash received before revenue is earned
 Examples:
• Insurance collected in advance
• Subscriptions collected in advance
• Gift certificates
 Receipts are initially recorded as liabilities
(unearned or refundable receipts) and recorded as
revenues in future periods when earned
Deferred Revenue Example
Received $2,400 for an insurance policy in advance on
September 1
Initial journal entry:
9/1 Cash
2,400
Insurance Collected in Advance
2,400
Monthly adjusting journal entry:
9/30 Insurance Collected in Advance
200
Insurance Revenue
200
($2,400 annual × 1/12 = $200 per month for 12 months)
Accrued Liability
Expense incurred before cash is paid
 Examples:
• Payroll
• Taxes
• Interest
 Record expense (and corresponding
liability) in period incurred; pay for it in a
future period
 No cash flow on recording, only when paid
Accrued Liability Example #1
Pay biweekly wages of $280,000
At end of month, between pay periods:
Wages Expense
40,000
Wages Payable
40,000
Next payday:
Wages Payable
Wages Expense
Cash
280,000
40,000
240,000
Accrued Liability Example #2
On March 1, assume a 9%, 90-day, $20,000
loan is taken out with a bank
Initial journal entry:
3/1 Cash
20,000
Note Payable
20,000
Monthly adjusting journal entry:
3/31 Interest Expense
150
Interest Payable
150
($20,000 principal × 9% × 3/12 = $450 for 3
months or $450/3 = $150 per month)
Accrued Asset
Revenue earned before cash is received
 Examples:
• Rent
• Interest
 Record revenue (and corresponding
receivable) in period earned; receive payment
in a future period
Accrued Asset Example
Rent payment of $2,500 due within first 10
days of month
First day of the month:
Rent Receivable
2,500
Rent Revenue
2,500
Upon receipt of cash:
Cash
2,500
Rent Receivable
2,500
Adjusting Entry Summary
Examples:
 Deferred Expense
cash received before expense is incurred
 Deferred Revenue
cash received before revenue is earned
 Accrued Liability
expense incurred before cash is paid
 Accrued Asset
revenue is earned before cash is received
Steps in the Accounting Cycle
7. Close the
accounts
1. Collect and
analyze info
6. Record and
post adjusting
entries
5. Prepare
financial
statements
2. Journalize
transactions
3. Post
transactions to
general ledger
4. Prepare
work sheet
LO6
The Closing Process
Purpose:
 To return the balance of revenue,
expense, and dividend accounts to
zero to begin the next period
 to transfer the net income of the
period to Retained Earnings
Nominal Accounts
Revenues
Expenses
Close to
Income
Summary
Normal
balance
Normal
balance
Close to
Income
Summary
$ XX
$ XX
$ XX
$ XX
Dividends
Normal
balance
Close to
Retained
Earnings
$ XX
$ XX
Zero out
nominal accounts
to start accumulation
of next period’s
results
LO7
Closing Entries
Income Summary
$XX
from expense
accounts
$XX
from revenue
accounts
(Net loss) or net income
closed to Retained Earnings
Appendix
Accounting Tools:
Work Sheets
Unadjusted Trial Balance Columns
Begin by filling in the
trial balance
accounts and amounts
LO8
The Adjusting Entries Columns
Make adjustments;
formal journal entries
are prepared later
Adjusted Trial Balance Columns
The Income Statement Columns
Extend revenue and expense
account balances to the
income statement
The Balance Sheet Columns
Extend asset, liability, and
equity accounts to the
balance sheet
End of Chapter 4